Plan B – where is the banking union heading? Speech delivered at the Banken- und Unternehmensabend at the Deutsche Bundesbank’s Regional Office

1 Introduction

Ladies and gentlemen

I am delighted to be with you here in Munich and to talk about issues that are on everyone's lips right now. To be precise, I have come here today to talk about the future of the European banking union, and thus, by extension, about the future of our currency area as a whole, too.

The connection between the two topics is easy to establish – banks play a special role in financing the economy in Europe and the euro area, which is why the stability of the banking sector is one of the key factors in ensuring the stability of the euro. And that’s why, a few years ago, at the height of the sovereign debt crisis, the banking union was established as a way of preventing the banking sector from amplifying future crises, or even igniting them itself.

But it must be clear that the banking union can only be one of many measures aimed at achieving the objective of a stable euro.

Work on taking the banking union to the next level has recently attracted an increasing amount of attention. The focus has mainly been on the third, as yet incomplete pillar – the European deposit insurance scheme. Judging by the debate and the media coverage, you could be forgiven for thinking that the common European deposit guarantee scheme is the be-all and end-all when it comes to further stabilising Europe's banking sector.

But that doesn’t reflect the real situation. And that’s why I would like to take a few minutes to give you an overview of the banking union project and how it is unfolding at present.

2 Where have we come from?

To put the current work items into the right context, we first need to cast our minds back to the path which led us here; in other words, the setting in which the banking union was originally established.

Hot on the heels of the global financial crisis, Europe – and especially the euro area – was engulfed by both a sovereign debt crisis and a banking crisis. And these crises fuelled one another. Crumbling public finances and tough financing conditions in some member states put domestic credit institutions under pressure because they were holding huge stocks of their home countries’ government bonds. At the same time, there was a danger that governments would be forced to step in and shore up domestic credit institutions, thus potentially getting into financial difficulties themselves.

However, the main sticking point was the contagion risk hanging over the euro area. Because the crisis brought to light the lack of any protective measures whatsoever to prevent contagion from rippling across national borders. Banks in the euro area were also affected, whether through financial links, fire sales by individual institutions, which put assets as a whole under pressure, or a general crisis of confidence across the sector.

It's a hypothetical question whether the crisis in Europe could have been prevented entirely if the banks had been fundamentally sound. In any case, it quickly became clear that simply tweaking the national supervisory regimes was not going to be enough to counteract the contagion channel I have just mentioned. There's no denying that national supervisors had often been too lenient. On top of this, there were concerns that banks might also have to be recapitalised directly using European funds. But to tackle the problems effectively, a cross-border European solution was needed. Once this had dawned on politicians, they wasted no time in taking action. In November 2014, just two years or so after the initial concept was presented to the European Parliament, the first pillar of the banking union, the Single Supervisory Mechanism (SSM), became operational. The second pillar, the European Single Resolution Mechanism (SRM) has been fully operational since the beginning of 2016.

The determined manner in which the banking union was established exemplifies the common interest across all the euro area countries to adopt this solution. And that's hardly surprising – after all, a robust and uniform supervisory approach that also preserves national influence and leeway is to the advantage of all the member states involved. The crisis, which had reached its peak, swept away any qualms the countries might have had about a shared supervisory regime. 

For all the talk about shaping the future of the banking union, we should not lose sight of the key objective which all the countries involved are striving to achieve, which is to make an effective and appropriate contribution to protecting ourselves from crises.

3 Where do we stand right now?

Where do we stand right now in terms of preventing banking crises in the euro area? It's safe to say the debate about the outlook for the banking union hasn’t come out of thin air. There's certainly no denying that structural risks still persist in the European banking sector that make it, and thus the euro area as a whole, susceptible to crises. The still-high holdings of government bonds on the books of domestic banks and stocks of non-performing loans on the balance sheets of institutions in some member states are just two such risks I could mention.

It makes sense, then, to explore ways in which matters could be improved.

Does this give us an accurate portrayal and assessment of the situation today? It is important to me that we see the status quo as part of the bigger picture.

Otherwise, we risk overlooking not just the successes that the banking union has chalked up, but also the longer time horizon that needs to be the backdrop for assessing the recovery process in the European banking sector.

On the first point, European institutions have become far more robust on aggregate since the years when the crisis was raging. And the SSM was instrumental in achieving this – for one thing, before it took on its supervisory role, it conducted an asset quality review at the largest euro area institutions, prescribing adjustments of almost €50 billion to carrying values, as well as mandatory capital increases totalling €25 billion. For another, it is looking to preserve supervisory quality by pursuing new measures such as the targeted review of the internal models used by banks to calculate their risks. The final point we shouldn't discount is that the SSM, led by the ECB and with the support of supervisors from across the euro area, has announced its intention to combat the home bias shown by national supervisors. The SRM, too, generally came through its baptism of fire unscathed. In the case of one large European bank, it demonstrated that it is indeed possible for ailing banks to exit the market overnight without weighing on public funds.

These are successes that shouldn't be understated.

As for the second point, we should not ignore the time horizon.

Let me remind you that it will take time for the European banking sector to recover fully, unfortunately, and progress is of course especially arduous in the years immediately following a financial crisis. This healing process is still not complete to this day. But it is equally clear that, bolstered by broadly based and strong economic activity across the euro area, institutions today should be better placed than ever to take resolute action in ensuring their own resilience to risk.

What is more, some changes have been set in motion which will only become fully effective in the future. I’m thinking, for example, of the increase in loss-absorbing capital, which needs to be available in a resolution event and so should give the resolvability of institutions a significant boost. The associated MREL requirements assigned to each institution individually are currently being sent to the institutions. I would like to flank this statement with a call on all institutions to also comply with their MREL target coverage in future, of course. Consider also the Single Resolution Fund, which is set to swell to around €50-60 billion by 2023 from bank levies and is provided for the purpose of carrying out resolutions – currently, the fund’s volume amounts to around €17 billion.

So what can we say about the situation at large today? The brief overview I’ve given in the last few minutes ought to have shown that, in terms of the banking union, considerable successes have been achieved and scope for further action still exists. The challenge now, then, is to adapt the prudential and regulatory framework for European banking in a considered and targeted manner wherever there is room for improvement.

4 Where are we heading?

So having ascertained where we have come from and where we stand today in terms of the European banking union, the obvious next question is: where are we heading?

Some believe that the third pillar of the banking union, namely a common deposit insurance scheme, would play a crucial role in solving the most urgent problems. Here I would like to take the wind out of their sails somewhat and point out that national deposit insurance schemes are already in existence today, which have now been harmonised across Europe. Retail customers’ deposits of up to €100,000 per bank are guaranteed in every member state. Looking ahead, a European deposit insurance scheme may indeed bring an additional benefit to a degree, such as serving as a reinsurance facility for national systems and thus boosting the resilience and trustworthiness of deposit insurance schemes as a whole. At this point you may have already discerned that the specific architecture of a deposit insurance scheme like this is integral to its success. From Germany’s perspective, it would, above all, have to incorporate institutional protection schemes, which exist in the savings bank and cooperative bank sector and whose economic benefits have been proven.

But I don’t want to delve into too much detail here for fear of pushing much more urgent topics into the background.

To recap, everyone would benefit from a more crisis-proof banking system in Europe. But as I explained earlier, the banking union is a sine qua non for stability in the euro area, albeit an insufficient one. And that even applies to the banking sector: the banking union can only ever be as successful as its environment permits. Pertinent in this regard is the continual existence of regulatory loopholes.

I’m referring here specifically to government bonds. Today, institutions continue to have relatively high stocks of sovereign paper on their books issued by the country in which they are based. One of the primary reasons for this can be found in the current regulations: under the standardised approach for credit risk, banks still don’t have to set aside a single euro in capital to account for the risk that their domestic government will be unable to honour its financial obligations. This regulation applies even though government bonds make up a large part of banks’ balance sheets in the euro area and the economic risk of sovereign default may be low but never equal to zero.

The banking union can do very little to counteract this regulatory loophole. Though supervisors could address risks arising from government bonds at individual institutions as part of their supervisory activities, these risks are, of course, only one of the many types of risk that are included in the supervisory review process. Moreover, this risk category is treated very differently by supervisors within the Single Supervisory Mechanism. We at the Bundesbank, however, believe that the risks arising from government bonds require standardised, rules-based treatment.

Regulatory treatment like this would consist of two components: a risk weight for risks arising from sovereign exposures, and an upper limit for lending to individual governments.

Why am I talking about this when my talk is supposed to be about the issue of taking the banking union to the next level? Because the two topics are linked. Insufficient regulation in the area of government bonds increases the risk of a bank faltering. This in turn makes it more likely that a deposit insurance scheme will have to step in. If a European deposit insurance scheme were to be introduced without the risk of government debt on banks’ balance sheets having been sufficiently mitigated beforehand by suitable regulation, this would violate a key tenet of the market economy, namely that those who act and take on risks should also be liable for those risks. Developing deposit insurance in isolation, then, would do nothing to reduce risk. Quite the opposite, in fact: it can be expected that political urgency with regard to this and other unpleasant topics will diminish, if anything. European policymakers therefore first have to ensure that they get a good-enough grip on the risk in question before the third pillar of the banking union is expanded.

This is ultimately a case that can be made for all the action items that the Bundesbank is emphasising as prerequisites for expanding upon deposit insurance in Europe. All the structural risks to which banks in the euro area are known to be exposed must be kept to a tolerable level, including, in particular, the high level of non-performing loans still clogging up banks’ balance sheets in some euro area countries. To give you some idea of the problem: the total sum of non-performing loans – or NPLs for short – held by the large banks in the banking union alone comes to €760 billion.

While we have witnessed a significant drop in NPL shares across Europe and also within the SSM’s supervisory perimeter in recent years, and in some countries, such as Germany, NPLs were hardly a problem or were only confined to specific sectors, even in times of crisis, in other countries success so far has been meagre, and NPL shares there are still very high. This is why I expressly welcome the fact that the SSM is addressing this problem, for instance, by issuing guidance on how supervisors expect credit institutions to handle their NPLs. The European institutions, too, are working on a bundle of measures relating to the issue of NPLs, which is set to be implemented before the end of this year.

I hope that the determination with which this subject was approached will continue. In terms of taking the banking union to the next level, NPLs will have to be reduced once for all and national insolvency regimes will have to be harmonised before a fully-fledged third pillar can be added to the banking union’s architecture.

This ultimately also applies to country-specific risks that arise from each country’s individual legal situation in areas such as insolvency law, which can then have an impact on national banking. Solutions will have to be found for this first, too.

5 Conclusion

Ladies and gentlemen, this brings me to the end of my brief overview of the banking union and the problems facing the European banking sector.

Though I mentioned the development of the third pillar as a sensible area of action, in principle, I have surely also been able to make it clear why I consider other actionable areas to be more important and more urgent. Only once these outstanding topics have been clarified should we turn our thoughts to a single deposit insurance scheme that is more than just a harmonisation of national systems. Thank you for your attention.